The Impact of Rising Interest Rates on Housing Affordability

According to Freddie Mac, the average interest rate on a 30-year fixed rate mortgage rose by 8 basis points over the week to 4.39%. Since the beginning of the year, mortgage rates have risen by about 1 percentage point and are now at a level last seen in August 2011.

The rapid rise in mortgage interest rates could affect housing affordability through higher monthly mortgage payments. However, monthly mortgage payments are not the only path by which rising interest rates can affect affordability. Homebuyers can instead decide to raise their downpayment amount in order to maintain an otherwise constant monthly payment in the face of rising rates.

Table 1 shows the impact of rising mortgage rates on downpayments for this scenario. As interest rates rise, homebuyers increase their downpayment in order to keep monthly mortgage payments roughly the same. However, the required increase in the downpayment, both in levels and as a share of the house price, declines as mortgage rates rise. If the downpayment remained at 10% even as mortgages rates rose, then the monthly mortgage payments on a $180,000 mortgage, $912 at a 4.50% mortgage rate, would rise to $994 if mortgage rates rose to 5.25% and to $1,079 if mortgage rates rose to 6.0%.

Presentation1

Alternately, homebuyers seeking to maintain affordable monthly mortgage payments may lower their bid price on a home. In aggregate, lower bids that are accepted by house sellers could depress house price growth, partly offsetting recent gains.

Table 2 assumes, as an example, that the total cost of higher mortgage rates is evenly split between a lower bid and a higher downpayment in order to maintain affordable monthly mortgage payments. the required downpayment percent rises as in Table 1 but at a slower rate.

Presentation2

This exercise illustrates that rising mortgage rates can increase monthly mortgage payments, but a larger downpayment can offset this effect. However, accumulating a larger downpayment may be difficult, especially for recent homeowners with little home equity, as well as first-time home buyers.

These numbers illustrate a large issue challenging the demand side of the housing market, which is connected to the issue of pent-up housing demand. Obtaining a mortgage to buy a home, including accumulating the necessary downpayment, is in many ways a greater hindrance for the market than recent rate increases.

Regardless, rising mortgage interest expense by homeowners is a reminder of the importance of the mortgage interest deduction  (MID) in terms of supporting housing demand. As prospective homebuyers face larger interest payments, the value of the MID increases.

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5 Responses to The Impact of Rising Interest Rates on Housing Affordability

  1. […] impact of rising interest rates on housing affordability [Eye on […]

  2. […] In addition to the macroeconomic consequences, research from a team of Harvard and Berkeley economists found that the MID is positively linked with economic opportunity. By reducing the after-tax cost of buying a home with a mortgage, the MID increases income mobility across generations. In contrast, rising effective mortgage interest rates can cause prospective home buyers to delay home purchases, …. […]

  3. […] In addition to the macroeconomic consequences, research from a team of Harvard and Berkeley economists found that the MID is positively linked with economic opportunity. By reducing the after-tax cost of buying a home with a mortgage, the MID increases income mobility across generations. In contrast, rising effective mortgage interest rates can cause prospective home buyers to delay home purchases, …. […]

  4. kitsVA says:

    Higher interest rate means same house costs less, hence lower loan amount. What common sense tells me is lower loan amount is always smarter approach in buying a house as it gives room for more savings in life when you refinance the house when interest rates drop.

    For example, I saw a house listed for $875k in May when interest rates where very low and they sold it easily as some poor buyer thought it’s smart to buy it when interest rates where low. A very similar size house which looked way better was recently listed for 855k as interest rates went up. It didn’t sell and they had to drop it to $810K to sell it. The second buy maybe having same monthly payment on the first buyer buy his loan is probably 65K less for better house. So, when interest rates drop in future, he could refinance and enjoy much lower payment than first buyer as his loan amount is way smaller.

  5. […] Rising interest rates have reduced affordability for some of these buyers, which means having to increase downpayments or alter home price budgets. Policy changes that would further increase the cost of purchasing a home would further set back […]

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